This remains the million dollar question as there are plausible arguments for both the bulls and the bears. The bears will argue that geopolitical risks (the PIIGS) still exist, inflation is coming on fast and bullish sentiment is rampant. Bulls will counter that there are more skeptics than exuberant cheerleaders, that the economy is finally gaining traction and that earnings will continue to improve. They argue this will lower valuations even if the market climbs a bit more here. The hard part is deciphering which opinion is correct as we can see validity in both arguments.

Thus the current market environment creates a double-edged sword. In one respect, if we are in the midst of a melt-up, it is hard not to stay exposed (invested) and fully participate. On the other hand, if we are in the last turn (about to correct) in the market’s game of musical chairs, it would stink to get caught without a chair! If you are not worried about either of these scenarios you’re not properly game planning for risk management

That said, the pros are the trends for three key bellwether indices; the Transports, the Banks and the S&P 500 remain up and intact, though this morning’s action in Citigroup (C) may cap the momentum in the banks for a while. Additionally, and as mentioned before, the economy is finally gaining some traction on the job creation front. The cons are the market is very overbought, measured sentiment (not anecdotal) is a bit overbullish, and inflationary pressures in basics such as food and energy are ramping up.

So how does one play this game, given the confusing but equally plausible messages being sent by the market? Well, first we need to differentiate between older-dated holdings and new money. Older-dated holdings are easy as we make the assumption, given the market run-up since 2009, that the cost basis on these positions are markedly lower than present prices. In this case it is easy to just keep raising stops and let the market take you out on a correction.

The harder question to answer is what to do with new money or cash on the sidelines. Here we suggest a more cautious approach as we do believe, given the divergences developing between internals and market price momentum, that a correction is coming sooner rather than later. Thus we suggest being extremely selective when putting on new positions and keep stops very tight and, more importantly, honor them if triggered.

Below we see the current technical setup for the S&P 500 Index. As can be seen the Index is approaching 1,300, which is its next test of overhead resistance (gold line) and a solid round number that psychologically could stop the market. A target above that would be near 1,330, which represents the upper end of the present bullish channel the index is in (purple lines). On the downside, near-term support comes into play near 1,275 with more solid support near 1,250 (upper red dotted line).

So, in the end you’re left with either trying to anticipate the correction (proactive) or waiting for more evidence it is actually under way (reactive). The former would be done by seeing the widening divergences between price and momentum indicators and continued rise in bullish sentiment, while the latter would wait for a few days of aggressive selling where down volume and decliners swamp up volume and advancers. It is a pick-your-comfort-level strategy. Some like to be anticipatory; however, in doing so you run the risk of leaving the table before dessert is served. Others like to be more convinced; the risk here is you can get stuck with the bill! In the process you can give back quite a few basis points waiting for more evidence to unfold.

The bottom line is there are always varying degrees of risks and rewards. Sometimes one is so much greater than the other that decisions are very easy. However, other times such as the present, it is not as clear. That said, we believe at present there is heightened risk, thus we remain long but underinvested and are deploying new money at present levels only when very enticing risk/reward setups occur. With the tape running it can be very easy to be pavlovian and triggered into impulsive decisions. However, investing takes the patience and cunning of a lion, knowing when to pounce and when to conserve energy. The time to pounce is when the likelihood of the kill is the greatest and stacked in your favor, and right now we just don’t see it that way.

However, as we all know, things change very rapidly nowadays and if more evidence appears to change the outlook we will change with it. In the interim we’ll keep eyeing the unbiased data for additional clues that will help tip the risk/reward scale in a more decisive direction.